U.S. inflation has exceeded the Federal Reserve’s 2% annual target for more than five years and did so again in May, rising 4.2% on an annual basis, as measured by the consumer price index. Similarly, economists expect the personal consumption expenditures price index, the Fed’s preferred inflation measure, to top 4% year to year when the Bureau of Economic Analysis reports the May reading later this month.
It is tempting to call 3%, or even 4%, the new 2%, as some Fed watchers have snidely asserted. But the Fed’s failure to meet its own inflation target is no laughing matter. Missing the mark poses a serious credibility issue for the central bank. It also threatens the U.S. consumer’s financial health, on which the economy’s growth depends, and it raises the risk that elevated inflation becomes entrenched.
“It’s probably more important than ever that the Fed not only has a 2% inflation target, but commits to achieving it,” says Diane Swonk, chief economist at KPMG.
Although the Fed’s mandate to maintain price stability has been in place for decades, policymakers publicized a specific inflation target relatively recently. While the Fed first raised the issue of a target level in the mid-1990s, it didn’t adopt an explicit inflation target of 2%, as measured by the PCE price index, until 2012, under former Fed Chair Ben Bernanke.
Bernanke was a driving force in codifying the 2% goal, noting at the time that several studies had found that 2% was the lowest inflation rate for which the risk was small that the federal-funds rate would hit zero, or in economic-speak, the zero lower bound. The Fed can’t cut rates further to effectively stimulate the economy once they have fallen to that level.
The 2% target thus provides a cushion, especially in a recession. A zero-percent target would leave little room for error, as even a minor shock could result in deflation, or falling prices, arguably as bad an outcome, or worse, than inflation.
There is little reason to think the Fed will achieve its 2% mandate in the near future. Members of the Federal Open Market Committee, the Fed‘’s policymaking arm, will release their latest summary of economic projections on June 17, at the conclusion of a two-day FOMC meeting. Projections in the past few SEPs put the return to 2% inflation at least three years out.
May could mark a peak in inflation, but there are many reasons to think that price growth won’t trend much lower this year, including the continuing impact of an oil-price shock, higher tariffs, surging datacenter demand tied to the buildout of artificial intelligence, and the potential for escalating shipping costs and pressures on the agricultural sector. More likely, inflation may plateau around 4%.
Service-sector inflation remains more than 1.5 percentage points above pre-Covid norms. Plus, prices for more than 40% of items tracked by the CPI are growing by 3% or more a year, compared with just 18% of items before the Covid pandemic, according to Mike Reid, head of U.S. economics at Royal Bank of Canada.
Higher inflation has a particularly pernicious effect on U.S. households. It is the most regressive tax, Swonk says. Average hourly earnings decreased by 0.1% in May when adjusted for inflation, the Bureau of Labor Statistics reported Wednesday.
While most well-off households have been benefiting from the wealth effect engendered by long-running bull markets in stocks and real estate, lower- and middle-income households more dependent on wage growth are feeling the squeeze. The disparity is fueling inequality to a degree that may be closer to the Gilded Age of the late 1800s than the inflationary 1970s, says Swonk.
That is why multiple officials have rejected the idea of raising the inflation target to something more achievable. Even in 2022, when the CPI peaked at nearly 9% and the economic cost to bring it down seemed steep, James Bullard, then head of the St. Louis Fed, said scrapping the 2% target was a bad idea.
“This is a way to squander your credibility and make the [19]70s magically reappear, and The Bee Gees will be back on tour,” Bullard said at the time. “To have a major central bank deviate from the international standard I think would set up chaos around the world on inflation.”
Not to mention music.
Write to Megan Leonhardt at megan.leonhardt@barrons.com